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Capital Structure in Banks 175
loans typically have much higher ultimate losses than do collateralized
or secured loans.
EL due to transfer or country risk can be modeled similarly to this
approach and has basically the same three components (PD of the country,
195 EA, and LR due to country risk 196 ). However, there are some more
specific aspects to consider, which we will not deal with in this book. For
instance, since a borrower can default due to counterparty and country risk
at the same time, one would need to adjust for the “overlap” because the
bank can only lose its money once.
Likewise, we will not deal with the parameterization 197 of this model in
this book, but there are many pitfalls when correctly determining the components
in practice.
By definition, EL does not itself constitute risk. If losses always equaled
their expected levels, there would be no uncertainty, and there would be no
economic rationale to hold capital against credit risk. Risk arises from the
variation in loss levels—which for credit risk is due to unexpected losses
(UL). As we will see shortly, unexpected loss is the standard deviation of
credit losses, and can be calculated at the transaction and portfolio level.
Unexpected loss is the primary driver of the amount of economic capital
required for credit risk.
Unexpected loss is translated into economic capital for credit risk in
three steps, which are—as already indicated—discussed in turn: first, the
standalone unexpected loss is calculated (see the “Unexpected Losses” section
which follows). Then, the contribution of the standalone UL to the UL
of the bank portfolio is determined (see the “Unexpected Loss Contribution”
section later in this chapter). Finally, this unexpected loss contribution
(ULC) is translated into economic capital by determining the distance between
EL and the confidence level to which the portfolio is intended to be
backed by economic capital (see the “Economic Capital for Credit Risk”
section later in this chapter).
195 Typically estimated using the input from the Economics/Research Department of
the bank and/or using the information from the spreads of sovereign Eurobonds, see
Meybom and Reinhart (1999).
196 The calculation of LR due to country risk is broken into (the product of) two
parts: (1) loss rate given a country risk event, which is a function of the characteristics
of the country of risk (i.e., where EA is located) and (2) the country risk type,
which is a function of the facility type (e.g., recognizing the differences between shortterm
export finance and long-term project finance that can be subject to nationalization,
and so on).
197 We will not deal with the estimation and determination of the various input factors
for specific customer and product segments. See, for a discussion, Ong (1999),
pp. 104–108.